Last Updated on Dec 6, 2022 by Aradhana Gotur
‘How do you pick mutual fund schemes for investment?’
Ask most investors and they would say that they compare the historic returns and then pick schemes that offer the highest returns among their peers. But how exactly is a mutual fund return calculated? CAGR and XIRR are two popular terms used when we talk about mutual fund returns. While many confuse the two to mean the same, CAGR and XIRR are quite different. Let’s understand what they are along with XIRR Vs CAGR.
Table of Contents
What is CAGR?
CAGR is the abbreviation of Compounded Annual Growth Rate. It is the most basic tool for measuring the return generated by a mutual fund scheme. The CAGR shows the average annual returns of a mutual fund investment over a specified period. So, if you invest in a mutual fund scheme over five years, the CAGR would depict the average rate of return that the scheme yielded every year for the past five years.
CAGR is calculated using the following formula:
CAGR = [(Value of the fund at the end of the tenure/value of the fund at the beginning) ^ 1/n] – 1
In the formula, ‘n’ is the tenure.
So, if you invest Rs 5 lakh for 5 yrs after which the value of your investment is Rs. 7 lakh, the CAGR would be calculated as follows:
CAGR = [(7,00,000/5,00,000)^⅕] – 1 = 6.96%
So, CAGR shows that your investment of Rs. 5 lakh earned an average annual return of 6.96% for five years, amounting to Rs. 7 lakh at the end of your investment horizon.
Application of CAGR
CAGR is a quick way to check the returns of your mutual fund investments. When you compare different mutual fund schemes, their CAGR is the usual figure which is expressed as the return over different periods, like 3 months, 6 months, 1 yr, 3 yrs, and other time frames. CAGR is an effective way to determine the returns for a lump sum amount of investment for a specified tenure.
Limitations of CAGR
CAGR does not give an accurate historic return in the case of multiple investments during the tenure. If you are investing in one lump sum, you can calculate the CAGR to know the return yielded by your investment. However, if you are investing haphazardly in instalments or you choose the Systematic Investment Plans (SIPs) mode of investment, the CAGR may not give you the correct returns. In that case, you would have to calculate using other measures to get the correct return generated by your portfolio.
Moreover, CAGR averages out the returns over the tenure. It does not show the actual return that you might have earned in one year. So, in the above calculation, the CAGR of 6.96% does not mean that the actual return of the fund was 6.96% every year. It might have been higher in some years and lower in others. The rate of 6.96% is the average compounded rate of return, not the actual return year on year.
What is XIRR?
XIRR, abbreviated for Extended Internal Rate of Return, is the measure that depicts the returns earned by your SIPs. In the case of SIPs, you make staggering investments rather than in lump sum. Even if you make haphazard investments at different time periods, XIRR would give the correct returns for such investments.
XIRR is nothing but the aggregated CAGR of each instalment of investment. So, if you invest in a SIP for 12 months, XIRR would be the CAGR of the last instalment (for 12 months) + the CAGR of the second last instalment (for 11 months) and so on.
Application of XIRR
XIRR is applicable in the case of periodic investments when the duration of each instalment varies. So, in SIPs, each instalment is invested for a month less than the previous. As such, XIRR gives the aggregate CAGR of each instalment. Similarly, over a one-year period, if you invest in the 3rd month, 5th month, and 10th month, XIRR would be the aggregate CAGR of each investment wherein the ‘n’ would be the 9th month, 7th month and 2nd month for the investments, respectively.
The difference between XIRR vs CAGR
Both XIRR and CAGR measure returns but their applications are quite different. Here are the main differences between these two types of returns:
|Definition||It is the average annual returns of a mutual fund investment over a specified period with a focus on initial and ending values only for investment.||It calculates the returns earned by your systematic investment plans, considering every cash flow.|
|Use||Applicable where the growth of investment is concerned. It only considers the initial and final value of investments and leaves out multiple cash flows, in or out. It is suitable only for a lump sum investment.||It is suitable for multiple cash flows/instalments done at different intervals of time and overcomes the limitation faced by CAGR.|
|Formula||=[( End Value of Investment/ Initial Value of Investment ) ^( 1/time period in concern )] – 1||= ∑CAGR of all instalments|
|Returns||It gives the absolute return over a period of time.||It gives annual returns only|
|Limitations||The technique does not work for short terms, say a 1-yr period.||The rate of return cannot be determined if the final redemption value is not entered.|
|Tenure||The tenure does not change.||The tenure differs based on the investment done at different times.|
XIRR vs CAGR – which one should you choose?
Your choice between XIRR and CAGR should be dictated by your investment. If you are investing in a lump sum, the CAGR would give you the return earned from your portfolio. In the case of SIPs or periodic investments, XIRR would give a more accurate picture. So, choose between these two returns based on how you invest.
Be a mindful investor when picking a mutual fund scheme. Understand how you should check the returns of the scheme. Use the CAGR or XIRR rates to assess your portfolio so that you can make the right investment decisions of either investing in a scheme or exiting from it depending on the returns generated.
1. Is XIRR monthly or annual compounding?
XIRR compounds annually, but it has the ability to provide results based on inputs from any given day. However, daily compounding results in a higher effective rate compared to annual compounding.
2. Is CAGR the same as IRR?
The Compounded Annual Growth Rate (CAGR) measures the returns on an investment over a specified period of time. Whereas the Internal Rate of Return (IRR) calculates the returns from a series of cash flows, given multiple transactions taking place at varying points of time which would all be considered at equal time intervals only.